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Following the rules to sustained profitability

The best companies don’t differentiate their products and services on price. They don’t try to solve problems by cutting costs or staff either.

Truly exceptional companies find success based on value, and they emphasise finding ways to make money before finding ways to save it. Top companies remain focused on those two principles and let everything else fall into place.

Those are the conclusions of two Deloitte thought leaders, Michael Raynor and Mumtaz Ahmed, who outline this seemingly simple path to greatness in a new book, The Three Rules: How Exceptional Companies Think.

Raynor and Ahmed studied 45 years’ worth of data on 25,000 US public companies, eventually naming 344 exceptional companies based on long-term profitability.

The authors went looking for specific behaviours such as focus on innovation, M&A activity or global expansion — traits they thought would separate the great organisations from the good ones, the consistently profitable from the occasionally profitable. But those traits didn’t seem to make companies great.

What they found whilst sifting through the data spanning 1966 to 2010: It wasn’t specific corporate actions but a focus on differentiation and revenue generation and how they made decisions in the first place that made companies great.

Or, as Raynor puts it: “How companies decide which path to take when they come to a fork in the road.”

CGMA Magazine asked Raynor what suggestions he had for companies that want to follow the rules, including changes that must be made and what hurdles they might have to clear. Following are some insights from the conversation.

PREPARE TO BATTLE HUMAN NATURE: “We have a well-studied and well-documented bias to the simple and familiar,” Raynor says. When a company is faced with competitive pressures and a loss in profitability, it often reacts by cutting price or reducing costs, and very often both. It’s the seemingly easier way out, but not the best way out.

“Thanks to the simplicity bias,” Raynor says, “even though a more complex and sophisticated solution in the form of increasing differentiation and driving revenue is the better response, it doesn’t look like the better response.”

He compares following the rules to choosing to eat broccoli over chocolate cake. We know we should eat broccoli, but the short-term benefit we get from chocolate cake is powerful. “Price-based competition and cost-cutting: That’s the chocolate cake of management,” Raynor says. “It’s so tempting that we find ways subconsciously to rationalise and to see those alternatives as appearing to be better.

“We say, ‘Yes, I know that most of the time, I really should be focused on differentiation. I know I can’t cut my way to greatness, but in this instance, I know it makes sense to cut costs. In this instance, it’s really OK to have the chocolate cake.’”

BEWARE SHORT-TERM THINKING: Intertwined with human nature is a focus on the near horizon. Companies know they can’t cut their way to long-term greatness. But they’ll make cuts in price or cost and justify it as a short-term solution. The research shows that this is a false hope. “It might improve your profitability, briefly, but it won’t give you exceptional profitability, even in the short run,” Raynor says. “I think people tend to miss this. Thinking short-term very often doesn’t help, even in the short term.”

GET FAMILIAR WITH YOUR COMPANY’S COMPETITIVE POSITION: Once a company understands the rules, it should assess its position relative to its competition and to its competition’s profitability. This is far easier said than done. Any company can provide a list of its competitors, but it’s not the company’s opinion that matters. “Your competition is whoever your customers say it is,” Raynor says. Asking your customers about competitors is a good first step. Then, a company must learn all it can about the competition, breaking down the product and service offerings to get a handle on the competition’s profitability. “It’s important to understand both how profitable you are relative to the competition and what their profit drivers are compared to you,” Raynor suggests.

COMMIT TO ACTUALLY DOING THE WORK TO MAKE YOUR COMPANY DIFFERENT: Figuring out a competitor’s pricing and products is, conceptually, not that hard, Raynor says, but he uses that as an example of the sort of painstaking tasks mediocre companies fail to do, or fail to do regularly. “What has held a lot of folks back from doing that work is it can seem expensive and time-consuming, and they haven’t seen a really good reason for doing it,” Raynor says. “In the absence of the belief that there’s anything to be gained, why would you go through all that misery? That’s a perfectly rational response.” But it’s a rational conclusion based on a false premise, he says. “These data are invaluable, and you can get enough information to make truly important decisions with far less time and expense than you think.”

Linear materially improved its performance by fundamentally changing its position and competing more on non-price dimensions of value.

Specifically, [it] reinvested its profits from early sources as a second-source supplier into capex and R&D, deliberately diversifying its customer base and product portfolio. The shift was gradual, but steady and unrelenting: by 2006 over 70 percent of revenues came from outside the United States, and government sales were less than 3 percent of total revenue. Although no single customer accounted for more than 10 percent of sales, Linear was focused on high-performance, mission-critical integrated circuits that typically were not a high proportion of its customers’ total cost. This combination of attributes allowed Linear to charge relatively higher prices and so capture much of the value it created.

For example, a representative Linear customer sold high-performance mobile data scanners for thousands of dollars. Linear’s chips improved battery life, a key differentiator for this product, yet one that accounted for less than 5 percent of the total materials cost for each scanner. Consequently, this customer typically looked elsewhere to ensure the cost competitiveness of its products, which allowed Linear significant pricing power.

In addition, with a highly diversified customer base, if this or pretty much any other customer became especially price sensitive, Linear was less compelled to accede to pricing pressures than say, Micropac [Industries], which had a much more concentrated customer base. Generalized across its portfolio of more than 15,000 customers, Linear was consistently in a position to capture a greater proportion of the value it created through higher prices than most other competitors in the industry.

IS AMAZON “EXCEPTIONAL”?

By the measures used to define exceptional companies, Amazon doesn’t yet fit the bill, Raynor says. But he believes the company continues to invest for growth.

“It’s intriguing to think about whether and how Amazon follows the rules,” he says. “In many markets it appears to be a price leader, and a big part of any pricing advantage it might enjoy could well be a function of lower cost. But I think what sets Amazon apart is that even where it has lower prices and lower cost, its service is fundamentally differentiated in many ways: selection, convenience, purchase suggestions, advances in shipping and so on. In short, Amazon has innovated, that is, broken some of the defining price, cost and quality trade-offs that have defined retailing for decades. The three rules speak to which tradeoffs you should embrace when they cannot be broken. My guess is that at some point Amazon will face a choice — it won’t be able to outrun these trade-offs forever, not with so many talented and motivated competitors fighting for the same space.”

THE THREE RULES

1. Better before cheaper. Don’t compete on price, compete on value. Price-based differentiation can lead to effective but not exceptional performance.

2. Revenue before cost. Increase profits through higher prices or higher volume. Taking that stance can lead to long-term profitability as opposed to taking the short-term approach of cutting costs.

3. There are no other rules. Businesses should be willing to change anything and maybe everything to stay aligned to the first two rules.

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